Active vs. Passive Investing: Do Actively Managed Funds Still Have A Future?

Do actively managed investment funds still have an important role to play for retail investors in the years and decades ahead? Despite the fact that the investment industry, both institutional and retail, has been built on actively managed funds, it’s become a serious question as passive index-tracking alternatives rise in popularity.

Despite that, there are still actively managed funds and fund managers that do consistently outperform benchmark indices. Here we’ll look at the continuing case why actively managed funds still have their place against the competition from cheaper, passively managed funds. There is room for both in a balanced, diversified portfolio and a strong argument why holding both is the best choice for investors.

The Rise Of Passive Index Tracker Investment Funds

It’s now a relatively well-known fact, at least among those in the industry or who regularly follow finance news, that a majority, and a large majority, of active fund managers fail to consistently beat their benchmark index. In October of last year, citywire.co.uk reported that S&P Dow Jones Indices, which conducts a twice-yearly study of funds' performance versus their own indices, highlighted a marked deterioration in UK equity fund manager performance:

“Over the year to the end of June, 81% of UK equity fund managers failed to beat the S&P United Kingdom BMI index. Funds lost an average 2.4% over the period, versus a 1.2% rise from the index. Over the previous 12-months, just under half of UK funds had outperformed the index”. 

The report painted an even worse picture for actively managed investment funds over the longer term:

“Over 10 years, around three-quarters of UK fund managers have underperformed. But even this lacklustre record is better than that from sterling-denominated funds investing in overseas markets. 

The picture is worst for US and global equity managers, with 92% of both lagging the index over the last decade”.

Even when actively managed funds do manage to outperform their benchmark index, the margin of improvement is often not enough to compensate for the higher fees actively managed funds charge – on average, around seven times higher than index-trackers.

More money than ever is now flowing into low cost index trackers. In fact, in September 2019, Bloomberg reported that August data from fund research and data company Morningstar showed that capital flows into passive funds had surpassed that into active funds for the first time. The data was on U.S.-based funds but as the largest capital market in the world, the trend depicted can be considered as offering insight into the wider global picture.

The rationale is clear. There’s a higher chance of an actively managed fund failing to beat the benchmark index than there is of it doing so. In that context, it’s easy to see why so many investors are asking themselves ‘why take the risk’?

Passive index tracking funds are not new and have been around since the 1970s. However, it wasn’t until the advent of online investment platforms that they became widely available to retail investors.

Their popularity has risen rapidly since the 2009 start of the bull market that has been running since the beginning of the recovery from the 2007 international financial crisis. With equity markets performing so well for over a decade now, active stock picking fund managers have struggled to beat their benchmark index. And with the additional incentive of passive funds charging an average of 7 times less than actively managed funds, investors have shifted more and more of their capital into them.

The Inherent Dissonance Within Index-Tracking Investment Funds

All of the above might paint a picture of there being little justification why any investor would put their money into an actively managed investment fund in favour of a passive benchmark index tracker. But that’s not the case. Passive investment involves an inherent dissonance that means over the long term, it can’t make sense for a majority of investment capital to simply track indices.

Why? Capital markets like stock markets work on the principle of the market, made up of thousands of big investors and millions of smaller investors, finding the ‘true’ value of any given asset. That true value is based on supply and demand – what investors are willing to pay for an asset like company stock.

Investors decide what a company is worth based on a range of factors including its revenues, profits, costs, debts and performance of its management and executives. The market, made up of millions of investors, also takes into consideration a company’s future prospects.

For example, Tesla is worth more than traditional carmakers like General Motors and Ford despite the fact they make a lot more revenue and profit than it. That’s because investors believe that Tesla will make a lot more money than General Motors and Ford in the future, when all or most cars are electric vehicles.

Millions of investors all deciding what they think a stock market-listed company is worth, based on all of the information they have available to them, has proven to be a beautifully effective way of assigning a company its ‘true worth’. The market might, says the theory of market dynamics that modern capitalism is based on, overvalue or undervalue a company, or any other asset, for a period of time but it will always eventually return to fair value.

Or something might change inside the company, or outside the company, which changes its future prospects and fair value. Either way, the market will, even if with a delay, understand those changes and rebalance the valuation through the forces of supply and demand.

The job of active fund managers is to find assets that are temporarily undervalued by the market. They then profit from their return to their true or fair value when the market eventually realises they’ve been undervalued. Alternatively, by shorting a stock, investment fund managers can also potentially realise returns by correctly identifying companies the market is temporarily overvaluing after they then return to their true value.

Passive investment funds don’t buy shares in a company because someone has analysed a company’s financial situation, new products it hopes to bring to market, market trends and the competitive landscape and come to the conclusion they are temporarily undervalued or overvalued by the market. They buy shares in a company, at their current stock exchange-traded value, because, and only because, they form part of an index, like the FTSE 100 or S&P 500.

That means that if a majority of global investment capital were to be invested in passive index-tracking investment funds for any extended period of time, the overriding driver of any given company’s share price wouldn’t be their business performance, future prospects, risks and future threats. Their value would be based mainly on nothing more than the fact they form part of an index.

In theory, that could mean a poorly performing or even loss making company could continue, ad infinitum, to retain its position in an index like the FTSE 100, which is comprised of the 100 largest companies listed on the London Stock Exchange. Because all passive index trackers simply buy shares in all of the companies in an index, at the weighting they hold in the index, a majority of investment capital invested through passive funds would ‘break’ capital markets.

The market would no longer work in the way it is supposed to – valuing companies as accurately as possible based on all known information. Companies, or other assets, would be valued based on their being a constituent of an index. It would maintain, or go a long way to maintaining, the status quo.

Some critics of the trend towards ever greater amounts of capital being allocated to passive investment funds argue this is already skewing valuations. However, it is hard to tell how much at this stage. But the inherent nature of how index tracking investment funds work means that beyond a certain tipping point they certainly would lead to asset valuations becoming seriously detached from the fundamentals that normally inform exchange-traded valuations.

Do Actively Managed Investment Funds Have A Future?

The conclusion to the above has to be that sooner or later actively managed funds and stock picking will make a comeback. If the trend towards index-tracking investment continues, at some point it will lead to the more common occurrence of companies being obviously over or undervalued, simply by virtue by them being, or not being, constituents of popular indices. That will open up easy opportunities that stock pickers will take advantage of, improving their fortunes again.

Actively managed funds also tend to do better than index trackers during bear markets. When an economic downturn or crash hits, fund managers should be able to react and rebalance their fund’s holdings towards assets that will fare better in challenging conditions. An index-tracking investment fund will simply drop by as much as the index does.

At the end of the longest bull run in the history of stock markets, many investors will have almost forgotten what a bull market looks like. History demonstrates investors have short memories. When market conditions change and major indices plummet, investors can be expected to quickly rediscover their enthusiasm for actively managed investment funds.

Is It Better To Invest In Passive Or Active Investment Funds?

Passive tracker funds have a lot of advantages. They are cheap and have historically delivered strong, long term returns. They are also simple and de-risk investment for inexperienced retail investors.

But actively managed investment funds also have their strengths, for those investors who manage to avoid underperforming funds and fund managers. And the capital markets that are the foundation of our capitalist economies simply wouldn’t work if too much capital is invested passively. They wouldn’t effectively judge true value in the way they historically have.

Active funds, well researched for past performance and management, still have a role to play. And there are active fund managers who do consistently outperform the market. Actively managed funds are also a good way to gain diversified exposure to more niche sectors for which indices may not exist.

There is certainly room in an investment portfolio for active and passive investments. New, inexperienced investors could do a lot worse than building the foundations of their portfolio on major index-tracking investment funds. But as the portfolio grows there is also a strong argument for an allocation to quality actively managed funds.